YOUR MONEY-How to use ETFs as a buffer in volatile markets
By Beth Pinsker
NEW YORK, Sept 25 (Reuters) - When it comes to investing, how much are you willing to put on the line for the biggest possible gains? If bumpy markets are making you nervous, there is a middle ground emerging between being all-in or sitting on the sidelines.
Defined outcome exchange-traded funds (ETFs) offer a buffer against losses - meaning, if the market goes down, you do not necessarily lose money.
Most ETFs track an index and are a lower-cost alternative to funds that aim to beat the market. However, defined outcome ETFs are managed more actively - and act more like structured notes or certain annuities than plain-vanilla index funds.
"The whole idea is very simple, but it’s profound: It’s the ability to know upfront what your outcomes will be relative to what the S&P 500 does over the next year," said Bruce Bond, CEO of Innovator, who co-founded ETF giant PowerShares, now owned by Invesco.
To date, the funds offered by Innovator have tracked the S&P 500. The company said it will soon add defined outcome funds that track other indexes, like the Russell 2000.
THE FINE PRINT
Defined outcome funds are complex in nature. The structured notes they grew out of are a combination of bond and options contracts that investment advisers negotiate with financial institutions to help counter risk.
The defined outcome ETFs offered by Innovator are structured at three different levels to buffer against losses. The base option protects the holder from a 9% drop in the S&P 500 over the 365 days from the issue date. (A 15% buffer level operates the same way.)
A major catch is that there is also a cap on gains, meaning the holder knows they will not earn more than a certain amount, even if the market goes higher. There is no guaranteed return, as there might be in an annuity structure.
The cap on Innovator's September S&P 500 Buffer ETF BSEP.Z is 14.07%; it is 9.39% for the 15% level PSEP.Z.
The S&P 500 is currently up more than 19% for the year, but what it does from Sept. 1 for the next 365 days is anyone's guess.
Moreover, the details listed are only applicable if you buy a defined outcome ETF in the first days of issuance. After that, market conditions shift the parameters.
Since you can buy or sell an ETF at any time, you need to keep an eye on your gains and losses - s well as your tax consequences if not in a deferred account.
At the end of a defined outcome ETF's year-long term, your fund rolls forward into the next available issue for another 365 days, Bond said.
The most conservative option Innovator offers is a 30% buffer, but this does not kick in until after the first 5% of losses. So if the market is down 5%, that is all on you. The next 30% of losses are covered, and anything beyond that is back on you.
If the S&P falls 38% - like it did in 2008 - you would be out only 8%.
Such protection comes at a premium. Buyers pay a fee of 0.79% - higher than typical for ETF funds, but less than for mutual funds or a structured note.
Financial advisers are obviously taking notice, because assets under management at Innovator are about $1.3 billion to date, Bond said.
For one thing, these ETFs are easier to manage than dealing with negotiated contracts with banks, and you avoid credit risk issues. Plus, new clients can come in without waiting until the next contract, said Tom Balcom, a certified financial planner based in Fort Lauderdale, Florida.
Peter Palion, a certified financial planner in New York who investigated this option for clients, ultimately decided defined outcome ETFs are too complex.
"This does not give you full protection, and the amount of protection it gives is fairly expensive," he said.
Ken Nuttall, a certified financial planner in New York, is intrigued about defined outcome ETFs, but also worries about stress-testing the concept.
"That’s always the issue on any new ETF. The proof is in the pudding," he said.
Bond notes that the Innovator funds prevailed during a rocky period last October, when the S&P went below the buffer.
"It traded through. We had no issues," Bond said.
(Follow us @ReutersMoney or at http://www.reuters.com/finance/personal-finance. Editing by Lauren Young and Dan Grebler)